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Your Clients Will Pay for World’s Debt, Advisor Warns

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Romain Hatchuel has some sobering news: higher taxes are inevitable and there is not a lot (though there is something) that investment advisors can do for their affluent clients about it.

Hatchuel is managing principal of Square Advisors — the New York affiliate of the global investment advisory firm Square Capital, based in London and with offices in Paris and Luxembourg — that caters to high-net-worth and institutional investors.

While many others fill a similar role, advisors would do well to heed Hatchuel’s warning.

The French native humbly eschews making market forecasts, pointing out that many big names in the industry, whom he sees as having greater knowledge than he, generally get things wrong.

But when he’s not seeing clients at his offices on New York’s posh Upper East Side, Hatchuel does monitor capital market developments, pore over data from the International Monetary Fund and other sources, and has reported his findings in a series of op-eds published in The Wall Street Journal.

And he offers not a vain prediction but rather a generalized warning to any who will listen: the developed world’s debt tab has now come due and can no longer be evaded.

“At the end of the day, everyone gets what they deserve,” Hatchuel told ThinkAdvisor in a phone interview.

“The amount of economic growth that the Western world has enjoyed in the past 30 years just has not reflected true economic activity,” he says. “It has reflected true economic activity plus abnormal debt expenditure. So what we are experiencing today is [the result] of these years of inflated growth through excessive debt.”

So while the U.S. experienced GDP growth, on an inflation-adjusted basis, of 191% in the years 1950 to 1980 at a time when the nation’s aggregate debt grew by 12%, in the more recent three decades — between 1980 and 2010 — the U.S. experienced lesser GDP growth of 124% while debt grew 125%, Hatchuel laments.

“What rises abnormally through the abuse of a perfectly legal substance, which is called debt and which has clearly been abused over the past three decades, has to come down when the supply of that substance is reduced,” Hatchuel says.

“Today — for the past four to five years — we are at the inflection point. There has been too much [household] debt, the burden of which has been partially transferred to banks, then from banks to the government.

“Now that U.S. households have for the most part delevered and now that nonfinancial corporates have balance sheets that are generally in stellar shape, what is left is a huge pile of debt on the shoulder of the federal government,” Hatchuel continues. “This is going to have to be paid for one way or the other. Increased taxation, particularly on wealthiest Americans, is in my view one of the most logical means the U.S. government has at its disposal.”

While no fan of higher taxes, Hatchuel sees increased taxation as preferable to the alternatives, which include outright confiscation of wealth (e.g. Cyprus) or defaults on bonds (e.g. Greece).

“One way or another, the taxpayer will lose. It will be a little more orderly for the taxpayer to lose through taxation,” he says.

While Cyprus is a small country that many can’t find on a map, Hatchuel emphases that it was a large economic entity — the European Union — that imposed this draconian response, seizing as much as 100% of savings above 100,000 euros to assuage the Mediterranean island’s debt crisis.

“This bail-in plan that ended up rescuing Cyprus was designed, orchestrated and announced by European Union leaders. There were two plans. The original plan was even more severe and penalizing toward account holders. It didn’t protect accounts under 100,000 euros. There was outrage that the European Union would transgress the sacrosanct principle of insured bank deposits. But both plans came from the European Union leadership, not Cyprus,” he says.

The fact of Cyprus’ asset seizure may be of greater consequence than the fact that similar sorts of ideas are bandied about. But ideas have consequences — and influence on policymakers — and the fact that institutions such as the IMF have been beating the drums for wealth taxes in developed nations make their policy realization more feasible.

Hatchuel notes a recent IMF paper, little commented on, that proposes a one-off levy on the private wealth of affluent citizens in Western countries. Moreover, the IMF says that the U.S. is nowhere close to the optimal rate of taxation from a revenue-maximizing point of view, arguing that the top bracket’s current 45% average in combined federal, state and local taxes should be between 56% and 71%.

While a wealth tax would seem unsurprising in some countries — “France obviously comes to mind,” Hatchuel says — it goes against the U.S. grain.

“Even with Obama and a Democratic Congress, the U.S. remains fundamentally a capitalist country,” he says.

And yet, Hatchuel has observed that the drift toward higher taxation is slowly growing more mainstream in the U.S.

Sure, New York’s new Democratic mayor, Bill de Blasio, has proposed levying a tax on the wealthy to pay for universal preschool. But increased taxation is now “defended by people you would not necessarily have expected, such as [PIMCO’s] Bill Gross,” who recently railed against 1% Scrooges.

“He recommended that capital be taxed at the same rate as labor,” Hatchuel says of Gross’ proposal.

“But capital does not grow on trees, which means that when someone has amassed some capital, chances are that that capital has previously been taxed at least once or sometimes several times through income or inheritance or capital gains.

“Taxing capital gains at the same level as income would essentially mean taxing it at a much higher rate than income,” he continues. “I think there is a good set of reasons why capital gains should be treated differently from income even though it can be a popular opinion [to say] that the wealthy already have enough wealth and should be taxed higher. But Bill Gross is a very smart man, and anything he says should obviously be taken seriously.”

Given the current political and cultural climate in the U.S., Hatchuel foresees increasing taxes in the following areas — all short of an explicit wealth tax:

First, an increase in income tax rates is “a possibility, particularly when you look at historical rates of taxation, which in the not-so-distant past were much higher for high-income earners.”

A second likely development would be a change in the tax status of carried interest (essentially, performance fees for investment managers).

“Carried interest is treated as capital gains rather than ordinary income when everyone knows it’s really income. This will primarily affect hedge fund managers, private equity managers and other professionals in the financial sector,” he says.

A third change investors should expect is in the tax status of municipal bonds.

“I’m not saying the tax exemption will go away soon,” he says, “I don’t think it will. But I was interested to see in the heat of fiscal discussions about a year ago that [a changed tax status for] municipal bonds was one of the few… ideas that garnered bipartisan support and I think it will come back on the table at one point. I think there will be a cap rather than an outright elimination of the exemption, which is clearly something that benefits the wealthiest households in the U.S.”

So, with such changes afoot, what’s an investor to do? Hatchuel turns taciturn, but then offers de minimus practical advice.

“It is not in investors’ hands to decide how taxation will evolve,” he says. “I think the expectation is that they will evolve in a direction that will not be favorable for investors, particularly the wealthiest ones.”

Moreover, Hatchuel is not an advocate of tax schemes for the rich, as contemporary political campaign parlance has it.

“I would never advise anyone to play games with their taxes, especially now that we live in world that is so globalized and transparent. Taxes should be paid as and when they are due. You may find sophisticated tax advisors who will come up with a legal or supposedly legal scheme to minimize taxes. That’s not my business and…that’s not my advice to anyone.”

His only practical advice is that investors avail themselves of opportunities while they still exist, assuming they are financially prudent.

For example, so long as municipal bond investors remain exempt from federal (and sometimes state) taxes on the income, “this has value when you believe in the asset class and when you think the asset class is a safe place to be — and depending on the amount of duration risk that you are prepared to take,” Hatchuel says, who expects a grandfathering of existing bonds at such time as their tax benefits are one day capped.

As for investments subject to lower capital gains taxation, investors should similarly take advantage of that offer while it is available.

Alternatively, “income-oriented strategies should be included in a portfolio only if the investor concludes they have true value in terms of their asset allocation because obviously they have less value from a tax point of view,” he adds.

But the bottom line is that today’s developed world, budgetary imbalances imply higher taxation. “The debt is going to have to be paid for one way or another,” Hatchuel says.

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